Chapter 5: Intercompany Profit Transactions – Inventories Beams, Advanced Accounting 10e, Ch. 5 4/14/2017 Chapter 5: Intercompany Profit Transactions – Inventories by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 5-1 Pearson Education Inc., publishing as Prentice Hall 1

Intercompany Profits – Inventories: Objectives Understand the impact of intercompany profit for inventories on preparation of consolidation working papers. Apply the concepts of upstream versus downstream inventory transfers. Defer unrealized inventory profits remaining in ending inventory of either the parent or subsidiary. © Pearson Education, Inc. publishing as Prentice Hall 5-2

Objectives (cont.) Recognize realized, previously deferred inventory profits in the beginning inventory of either the parent or subsidiary. Adjust the calculations of noncontrolling interest amounts in the presence of intercompany inventory profits. © Pearson Education, Inc. publishing as Prentice Hall 5-3

1: Intercompany Inventory Profits Intercompany Profit Transactions – Inventories 1: Intercompany Inventory Profits © Pearson Education, Inc. publishing as Prentice Hall 5-4

Intercompany Transactions For consolidated financial statements, ARB No. 51 (as amended by FASB Statement No. 160) states: "intercompany balances and transactions shall be eliminated." Show income and financial position as if the intercompany transactions had never taken place. © Pearson Education, Inc. publishing as Prentice Hall 5-5

Intercompany Sales of Inventory Profits on intercompany sales of inventory All recognized if goods have been resold to outsiders Deferred if the goods are still held in inventory Previously deferred profits in beginning inventory are recognized Consider a FIFO inventory system Beginning inventories are sold Ending inventories are from current period © Pearson Education, Inc. publishing as Prentice Hall 5-6

No Intercompany Profits in Inventories During 2009, Pretty sold goods costing $1,000 to its subsidiary, Simple, at a gross profit of 30%. Simple had none of this inventory on hand at the end of 2009. Worksheet entry for 2009: All intercompany sales of inventories have been resold to outside parties, so remove the full sales price from both sales and cost of sales. Pretty's sales are reduced $1,429. Simple's cost of sales are reduced $1,429. The same entry is used if Simple sells to Pretty. Sales 1,429 Cost of sales Sales = $1,000 / (1-30%) = $1,429 © Pearson Education, Inc. publishing as Prentice Hall 5-7

Intercompany Profits Only in Ending Inventories Last year, 2009, Paul sold goods costing $500 to its subsidiary, Sal, at a gross profit of 25%. Sal had none of this inventory on hand at the end of 2009. During 2010, Paul sold additional goods costing $900 to Sal at a gross profit of 40%. Sal has $200 of these goods on hand at 12/31/2010. Worksheet entries for 2010: Sales 1,500 Cost of sales Sales = $900 / (1-40%) = $1,500 80 Inventory Ending inventory profit = $200 x 40% © Pearson Education, Inc. publishing as Prentice Hall 5-8

Intercompany Profits Beginning and Ending Inventories Last year, 2009, Pam sold goods costing $300 to its subsidiary, Sir, at mark-up of 25%. Sir had $120 of this inventory on hand at the end of 2009. During 2010, Pam sold additional goods costing $500 to Sir at a 30% mark-up. Sir has $260 of these goods on hand at 12/31/2010. Worksheet entries for 2010: Sales 650 Cost of sales Sales = $500 + 30%($500) = $650 60 Inventory Ending inv. profits = $260 x 30%/130% Investment in Subsidiary 24 Begin. inv. profits = $120 x 25%/125% = $24 © Pearson Education, Inc. publishing as Prentice Hall 5-9

2: Upstream & Downstream Inventory Sales Intercompany Profit Transactions – Inventories 2: Upstream & Downstream Inventory Sales © Pearson Education, Inc. publishing as Prentice Hall 5-10

Upstream and Downstream Sales Parent sells to subsidiary Subsidiary sells to parent Upstream Sales © Pearson Education, Inc. publishing as Prentice Hall 5-11

Intercompany Inventory Sales The worksheet entries for eliminating intercompany profits for downstream sales For upstream sales, the last entry would also include a debit to noncontrolling interest, splitting the profit to be realized between controlling and noncontrolling interests. Sales XXX Cost of sales For the intercompany sales price XX Inventory For the profits in ending inventory Investment in Subsidiary For the profits in beginning inventory © Pearson Education, Inc. publishing as Prentice Hall 5-12

Data for Example For the year ended 12/31/2011: Subsidiary income is $5,200 Subsidiary dividends are $3,000 Current amortization of acquisition price is $450 Intercompany (IC) sales information: IC sales during 2011 were $650 IC profits in ending inventory $60 IC profit in beginning inventory $24 © Pearson Education, Inc. publishing as Prentice Hall 5-13

Income Sharing with Downstream Sales – PARENT Makes Sale Subsidiary net income $5,200 Current amortizations (450) Adjusted income $4,750   Defer profits in EI (60) Recognize profits in BI 24 Income recognized $4,714 Subsidiary dividends $3,000 CI 80% share $3,800 (60) 24 $3,764   $2,400 Income from subsidiary NCI 20% share $950   $600 When parent makes the IC sale, the impact of deferring and recognizing profits falls all to the parent. © Pearson Education, Inc. publishing as Prentice Hall 5-14

Income Sharing with Upstream Sales – SUBSIDIARY Makes Sale Subsidiary net income $5,200 Current amortizations (450) Adjusted income $4,750   Defer profits in EI (60) Recognize profits in BI 24 Income recognized $4,714 Subsidiary dividends $3,000 CI 80% share $3,800 (48) 19.2 $3,771.2   $2,400 Income from subsidiary NCI 20% share $950.0 (12.0) 4.8   $942.8 $600 When subsidiary makes the IC sale, the impact of deferring and recognizing profits is split among controlling and noncontrolling interests. © Pearson Education, Inc. publishing as Prentice Hall 5-15

3: Unrealized Profits in Ending Inventories Intercompany Profit Transactions – Inventories 3: Unrealized Profits in Ending Inventories © Pearson Education, Inc. publishing as Prentice Hall 5-16

Ending Inventory on Hand Intercompany profits in ending inventory Eliminate at year end Working paper entry Cost of sales XXX Inventories For the unrealized profit © Pearson Education, Inc. publishing as Prentice Hall 5-17

Parent Accounting Porter owns 90% of Sorter acquired at book value (no amortizations). During the current year, Sorter reported $10,000 income. Porter sold goods to Sorter during the year for $15,000 including a profit of $6,250. Sorter still holds 40% of these goods at the end of the year. Unrealized profit in ending inventory 40%(6,250) = $2,500 Porter's Income from Sorter 90%(10,000) – 2,500 unreal. Profits = $6,500 Noncontrolling interest share 10%(10,000) = $1,000 © Pearson Education, Inc. publishing as Prentice Hall 5-18

Entries Porter's journal entry to record income Worksheet entries to eliminate intercompany sale and unrealized profits Investment in Sorter 6,500 Income from Sorter Sales 15,000 Cost of sales 2,500 Inventory © Pearson Education, Inc. publishing as Prentice Hall 5-19

Worksheet – Income Statement   Porter Sorter DR CR Consol Sales $100.0 $50.0 15.0 $135.0 Income from Sorter 6.5 0.0 Cost of sales (60.0) (35.0) 2.5 (82.5) Expenses (15.0) (5.0) (20.0) Noncontrolling interest share 1.0 (1.0) Controlling interest share $31.5 $7.5 There would be a credit adjustment to Inventory for 2.5 on the balance sheet portion of the worksheet. © Pearson Education, Inc. publishing as Prentice Hall 5-20

What if? If the sales had been upstream, by Sorter to Porter: Unrealized profits in ending inventory 40%(6,250) = $2,500 Porter's Income from Sorter 90%(10,000 – 2,500) = $6,750 Noncontrolling interest share 10%(10,000 – 2,500) = $750 Upstream profits impact both Controlling interest share © Pearson Education, Inc. publishing as Prentice Hall 5-21

4: Recognizing Profits from Beginning Inventories Intercompany Profit Transactions – Inventories 4: Recognizing Profits from Beginning Inventories © Pearson Education, Inc. publishing as Prentice Hall 5-22

Intercompany Profits in Beginning Inventory Unrealized profits in ending inventory one year Become Profits to be recognized in the beginning inventory of the next year! © Pearson Education, Inc. publishing as Prentice Hall 5-23

5: Impact on Noncontrolling Interest Intercompany Profit Transactions – Inventories 5: Impact on Noncontrolling Interest © Pearson Education, Inc. publishing as Prentice Hall 5-24

Direction of Sale and NCI The impact of unrealized profits in ending inventory and realizing profits in beginning inventory depends on the direction Downstream sales Full impact on parent Upstream sales Share impact between parent and noncontrolling interest © Pearson Education, Inc. publishing as Prentice Hall 5-25

Calculating Income and NCI Downstream sales: Income from sub = CI%(Sub's NI) – Profits in EI + Profits in BI Noncontrolling interest share = NCI%(Sub's NI) Upstream sales: = CI%(Sub's NI – Profits in EI + Profits in BI) = NCI%(Sub's NI – Profits in EI + Profits in BI) © Pearson Education, Inc. publishing as Prentice Hall 5-26

Upstream Example with Amortization Perry acquired 70% of Salt on 1/1/2009 for $420 when Salt's equity consisted of $200 capital stock and $200 retained earnings. Salt's inventory was understated by $50 and building, with a 20 year life, was understated by $100. Any excess is goodwill. During 2009, Salt sold goods costing $700 to Perry at a 20% markup. $240 of these goods were in Perry's ending inventory. In 2010, Salt sold goods costing $900 to Perry at a 25% markup and Perry still had $100 on hand at the end of the year. 2009 2010 Perry Salt Separate income $1,250 $705 $1,500 $745 Dividends $600 $280 $300 © Pearson Education, Inc. publishing as Prentice Hall 5-27

Analysis and Amortization Cost of 70% of Salt $420 Implied value of Salt 420/.70 $600 Book value 200 + 200 400 Excess $200   Unamort Amort Allocated to: 1/1/09 2009 1/1/10 2010 12/31/10 Inventory 50 (50) Building 100 (5) 95 90 Goodwill 200 (55) 145 140 © Pearson Education, Inc. publishing as Prentice Hall 5-28

2009 Income Sharing (Upstream) Salt's net income $705 Current amortizations (55) Adjusted income $650   Defer profits in EI (40) Income recognized $610 Subsidiary dividends $280 CI 70% share $455 ($28) $427   $196 Income from Salt NCI 30% share $195 ($12) $183   $84 © Pearson Education, Inc. publishing as Prentice Hall 5-29

Perry's 2009 Equity Entries Investment in Salt 420 Cash For acquisition of 70% of Salt 196 For dividends received 427 Income from Salt For share of income © Pearson Education, Inc. publishing as Prentice Hall 5-30

2009 Worksheet Entries Adjust for errors & omissions - none Eliminate intercompany profits and losses Eliminate income & dividends from sub. and bring Investment account to its beginning balance Sales 700 Cost of sales Cost of Sales 40 Inventory Income from Salt 427 Dividends 196 Investment in Salt 231 © Pearson Education, Inc. publishing as Prentice Hall 5-31

2009 Entries (2 of 3) Record noncontrolling interest in sub's earnings & dividends Eliminate reciprocal Investment & sub's equity balances Noncontrolling interest share 183 Dividends 84 Noncontrolling interest 99 Capital stock 200 Retained earnings Inventory 50 Building 100 Goodwill Investment in Salt 420 Noncontrolling interest 180 © Pearson Education, Inc. publishing as Prentice Hall 5-32

2009 Entries (3 of 3) Amortize fair value/book value differentials Eliminate other reciprocal balances – none Cost of sales 50 Inventory Depreciation expense 5 Building © Pearson Education, Inc. publishing as Prentice Hall 5-33

2010 Income Sharing (Upstream)   Salt's net income $745 Current amortizations (5) Adjusted income $740 Defer profits in EI (20) Realize profits from BI 40 Income recognized $760 Subsidiary dividends $300 CI 70% share $518 ($14) $28 $532   $210 Income from Salt NCI 30% share $222 ($6) $12 $228   $90 © Pearson Education, Inc. publishing as Prentice Hall 5-34

Perry's 2010 Equity Entries Cash 210 Investment in Salt For dividends received 532 Income from Salt For share of income © Pearson Education, Inc. publishing as Prentice Hall 5-35

2010 Worksheet Entries Adjust for errors & omissions - none Eliminate intercompany profits and losses Eliminate income & dividends from sub. and bring Investment account to its beginning balance Sales 900 Cost of sales Cost of Sales 20 Inventory Investment in Salt 28 Noncontrolling interest 12 40 Income from Salt 532 Dividends 210 Investment in Salt 322 © Pearson Education, Inc. publishing as Prentice Hall 5-36

2010 Entries (2 of 3) Record noncontrolling interest in sub's earnings & dividends Eliminate reciprocal Investment & sub's equity balances Noncontrolling interest share 228 Dividends 90 Noncontrolling interest 138 Capital stock 200 Retained earnings 625 Inventory Building 95 Goodwill 50 Investment in Salt 679 Noncontrolling interest 291 © Pearson Education, Inc. publishing as Prentice Hall 5-37

2010 Entries (3 of 3) Amortize fair value/book value differentials Eliminate other reciprocal balances – none Depreciation expense 5 Building © Pearson Education, Inc. publishing as Prentice Hall 5-38

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2009 Pearson Education, Inc.   Publishing as Prentice Hall © Pearson Education, Inc. publishing as Prentice Hall 5-39